When a U.S. Partnership is formed and has one or several foreign individual partners who do not live in the United States, the income of such partnership to the partners must be assessed as to its nature to the partners in order to determine the amount of tax withholding to withhold from each partner. The income must be classified as either business or investment income.
If the income is considered Business income, IRC Section 1446 will apply, Forms 8813, 8805, and 8804 must be filed on behalf of the partnership and foreign partners, and a withholding tax rate of 39.6% (highest income tax rate) must be applied to the taxable income allocated to each foreign partner. The income can be netted against expenses before applying withholding rate, and the foreign partners are still required to provide a W-8BEN form to the partnership per the instructions on the form. The income tax treaty in effect with any country does not change this or the withholding obligation.
If the income is designated as investment income, Forms 1042/1042S must be filed and a withholding tax rate of 30% is applied to the gross income (i.e. no deductions for expenses) allocated to each partner. The foreign partners should provide a W-8ECI form to the partnership per the instructions of the form.
Therefore, as indicated above, it must first be decided whether the income is subject to IRC Section 1446 withholding (39.6% of net business income), or IRC Section 1441 withholding (30% on investment income). Investment income is not subject to Section 1446 withholding but rather to Section 1441 withholding (no deductions for expenses). Generally, the former scenario (i.e. regular taxation) is a better scenario because the foreign individual can claim deductions, even though the income is subject to a 39.6% tax rate. It is important to note, however, that business rental income, although generally treated as a passive investment, is subject to the 39.6% Section 1446 withholding.
If there is any doubt whether the income is business income, the foreign partner can make an election under Section 871(d) for net basis taxation which he files with his U.S. tax return (1040NR). The foreign partner making the election should then provide to the partnership a Form W-8BEN.